Berkeley Thoughts

Do low interest rates lead to growth?

Central bankers have lots of theories. One of the theories for keeping interest rates low is so that businesses will become more apt to borrow. Central bankers hope that the the access to cheap credit will incentivize businesses to invest. As they invest in new projects and their businesses expand, they should, in theory, also begin to hire new employees. On a macro level the theory holds that low interest rates therefore should lead to growth in output and an increase in labor demand as new workers are needed to handle the growth of new output. This in turn should create a virtuous cycle of higher consumption, greater business confidence and even more investment.

After nearly 8 years of artificial interest rate suppression via our Federal Reserve, it begs the question how is the theory working out? Are low interest rates helping companies grow? The following chart lends an interesting perspective on that question. Below you will see the ratio of Debt-to-EBITDA for non-financial companies in the S&P 500. EBITDA ( an acronym for earnings before interest, taxes, depreciation and amortization) is a proxy for cash flow, it’s a good approximation for how much cash a company is generating in a given period of time.

What the chart above shows is that since 2011 the amount of debt taken on by S&P 500 companies has been rising at a faster rate than the cash flow from those companies has grown. The debt-to-EBITDA ratio now sits at multi-decade highs. What is going on? One of two things likely explain the rise of this ratio. 1) Companies are borrowing money cheaply and instead of investing in projects that will increase the profitability (cash flow) of their business are buying back their own stock instead. 2) Companies are investing in projects that are not as profitable or wouldn’t be funded at all at higher rates. Thus the cash flow isn’t able to grow at the same rate as the amount of debt; a lot of bad projects are getting funded. While scenario 1 might be good for stock shareholders neither seem particularly helpful for economic growth.

The first part of the central bank theory is working great; companies are borrowing at historic levels (see chart above) thanks to low interest rates. The 2nd part of the theory probably needs revisiting (as many have argued before) – all that borrowing doesn’t seem to be translating into growth. If it did, you would think at some point we would see EBITDA begin to catch back up with the amount of debt created. For the past six years the ratio has moved in one direction and it’s not a positive one if you are hoping in the theory that low interest rates will fuel a robust economy.